Blain's Morning Porridge - May 31st 2017 - What Inflation? Open your eyes and its right in front

Blain’s Morning Porridge – May 31st 2017

“I know that I am mad, but mother dearest, now, for this one time, I do not rave…. ”

Lots to think about this morning.

A line from a Bloomberg article y’day caught my eye: “The economy is too good and money is too cheap”. I emphasise it deliberately. Note it down. It sums up the underlying problem succinctly. The threats implied in one single line are legion – but who is worried about inflation?

I’m told by very senior economists and analysts from around the financial markets the inflationary threat is low and probably overestimated. After all, the comfortable consensus seems to be we’re in for a new normal of 20-yrs of stable but low growth.

Wake up and smell the fricking coffee! The consensus is the consensus until its decisively proved wrong!

If you don’t believe there is inflation stare deep into your Bloomberg screens and call up the price of any and all financial assets; bonds or stocks. If you want to see inflation in action, then Financial Asset Prices are screaming “Danger, Danger Will Robinson, Danger!” If you want inflation – there it is. Methinks all these clever people aren’t seeing the inflationary Forest because of the financial asset trees.

I’m quite sure some of these very smart folk will be saying: “Calm down Blain.. Low bond yields mean there is no inflation. Calm. Calm.” These folk forget its central bank distortion keeping rates so low – and too much money. Why are stocks so high? Because folk think the economy is recovering… which means it will heat up.. These are mutually exclusive events.

Even more surprising is an article in the FT based on a European Commission paper calling for the bundling of European Sovereign Debt into a “new financial instrument”. That sounds awfully like debt mutualisation – packaging debt into a common instrument. Will it be a joint and several liability – meaning all Eurozone nations effective become liable for each other? That sounds like a screaming NO! from the Germans.

You can understand why the ECB is pushing it. Basically, they are running out of capacity to buy sovereign bonds into the QE purchase programme. Their purchases must be weighted on a relative balance of each country. However, that causes a massive distortion – Bunds are running out. All the German banks want/need to hold them, and the Germans are in surplus so aren’t selling more.

Meanwhile, the liabilities of all the other countries are rising, and the current set up of the ECB means it can’t absorb them because it’s stuck with the relative weightings. It can’t buy more Italy unless it can balance them with more Germany – which it can’t find!!!

And hence the real reason we’re dancing around an EU taper – it’s absolutely nothing to do with the success of the policy in creating European Growth. (I very much doubt it has.) Its all about being trapped in relative weighting rules meaning it can’t buy more without the Germans making a fundamental shift.

Let me try and explain the threat by example: Italy has massive sovereign debt to refinance, the only people holding Italy debt are weak Italian banks and those who still believe the ECB has unlimited appetite to buy more.. Something has to give..

Both the factors above – the looming crisis I believe will hit financial asset prices later this year (a correction is coming), and a resumption of European Debt hostilities makes me very nervous. I’ve been wailing, Casandra-like, for years about the multitude of unsustainable realities underpinning markets. (Don’t encourage me by saying Casandra was eventually proved right… she was too late.)

Meanwhile, the surface noise of uncertainty in markets remains just as loud. We have an ongoing wobble in European stocks following the threat of electoral risk in Italy, and Greece having the temerity to get shirty about its next debt bailout.

Interesting to note a further slide in the price of Spain’s Banco Popular debt – highlighting the increasing the risks of a bail-in. The only realistic option for the bank is to be bought by another Spanish name, but yesterday we were seeing domestic sellers – strongly suggesting it’s increasingly unlikely. We’ve still got buyers, and we’ve been active both sides on POP paper. If you want to get out – this is probably the moment.

Meanwhile, the UK election gets more and more interesting. The Tory campaign looks off the rails and off message. Some polls now suggest its possible they will actually lose seats. On the face of it Corbyn appears to be attracting a strong, and very British, underdog vote – helped by an almost human performance on TV. We might have mis-judged this whole election, thinking it was about the need for Strong Brexit Politics and Firm Leadership. If it’s actually about personalities, then Theresa May is in more trouble than the polls suggest.

(And have you noticed how very very quiet Boris has been the last few weeks?)

On the other hand, I did read a very well argued paper from a US investment bank yesterday that the polls are wrong and may is still on for a 100 seat majority. It was full of very convincing charts and graphs – which I am sure explain exactly how the man on the Clapham Omibus makes political choices.

The effect on markets if May fails to secure a 50+ seat majority will be fascinating - last week we were talking about a nailed-on 100+ victory and Labour wipe out!)

I heard something on the radio about JPM arguing sterling will actually rise on a hung parliament on the basis we’ll be forced to negotiate a soft-Brexit. Bring me a quarter ounce of whatever they are smoking…..

We’re still a week away from potential Mayagedon!

Bring it on.

And some good news; Ben Ainslie kept British hopes in the America’s Cup afloat y’day – looks like the boat has a narrow sweet spot in 12-13 knots of wind – which is very light for Bermuda. Still, will keep us in contention for another week.

And finally, I’m off tonight to celebrate Celtic winning the European Cup back in May 1967. Service might be slow tomorrow!

Fastnet Charity: http://www.sail4cancer.org/fastnet-2017-bill-blain

Bill Blain